The Bank of England surprised financial markets yesterday by cutting British interest rates by 0.50 per cent rather than the 0.25 per cent reduction predicted by the majority of City forecasters.
The reduction by the Bank's monetary policy committee (MPC) takes bank "base rates" down to 6.75 per cent. It follows last month's 0.25 per cent cut which was widely criticised for being "too little, too late".
Committee members sanctioned the further rate cut following a gloomy assessment of prospects for a sharp slowdown in economic growth next year and concern about the deflationary risks of falling inflation. The reaction of the financial market was mixed.
Sterling fell only 0.76 pfennigs to 1.7589 deutschmarks on the belief that the next downward move in British interest rates would be postponed into 1999. But equities moved sharply lower with the FTSE 100 index falling 143.1 to 5,479.8 as investors responded to the pessimistic analysis of British economic growth prospects prompting the rate reduction.
"News about the international environment and the prospects for domestic activity have led the MPC to moderate its forecast for growth next year and to revise downwards its projection for inflation over the next two years," said the bank.
The medium term target is 2.5 per cent underlying inflation excluding the cost of mortgage interest payments and the bank's MPC has stressed that its interest rate policy seeks to avoid undershooting the target as much as to avoid exceeding it. By going for the larger 0.50 per cent rate reduction rather than the more cautious 0.25 per cent cut, it has effectively admitted that the British economy was "ex-inflation".
Most economic indicators have been signalling the passing of the inflation peak for some months. But MPC members have continued to worry about the possibility of wage inflation caused by the tightening labour market. Although jobless numbers are still falling, forecasts of a slowdown in growth next year from 2.5 per cent to 1.0 per cent or lower are likely to translate into higher unemployment before long.
Another major concern of the MPC has been the fear of imported inflation through a collapse in sterling if British interest rates are lowered towards European levels. Three months ago, the bank's economists warned about the inflationary consequences of sterling falling below DM2.78. Now, in a striking illustration of the dramatic change in economic circumstances, British interest rates have been reduced even though sterling is below that level and falling.
With the MPC less worried about devaluation, it is quite possible for the British currency to fall towards the DM2.50 area earmarked as the appropriate level for its entry into monetary union.
